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1 Federal Reserve Bank of New York Staff Reports Deficits, Public Debt Dynamics, and Tax and Spending Multipliers Matthew Denes Gauti B. Eggertsson Sophia Gilbukh Staff Report No. 551 February 2012 Revised September 2012 FRBNY Staff REPORTS This paper presents preliminary findings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments. The views expressed in this paper are those of the authors and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

2 Deficits, Public Debt Dynamics, and Tax and Spending Multipliers Matthew Denes, Gauti B. Eggertsson, and Sophia Gilbukh Federal Reserve Bank of New York Staff Reports, no. 551 February 2012; revised September 2012 JEL classification: E52, E62 Abstract Cutting government spending can increase the budget deficit at zero interest rates according to a standard New Keynesian model, calibrated with Bayesian methods. Similarly, increasing sales taxes can increase the budget deficit rather than reduce it. Both results suggest limitations of austerity measures. At zero interest rates, running budget deficits can be either expansionary or contractionary depending on how they interact with expectations about long-run taxes and spending. The effect of fiscal policy action is thus highly dependent on the policy regime. A successful stimulus, therefore, needs to specify how the budget is managed, not only in the short but also in the medium and long runs. Key words: fiscal policy, liquidity trap Denes: University of Pennsylvania. Eggertsson, Gilbukh: Federal Reserve Bank of New York ( The views expressed in this paper are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System.

3 1 Introduction What is the e ect of government spending cuts or tax hikes on the budget de cit? What is the e ect of the budget de cit itself on short-run and long-run outcomes? Does the answer to these questions depend upon the state of the economy? Does it matter, for example, if the short-term nominal interest rate is close to zero and the economy is experiencing a recession? These are basic and fundamental questions in macroeconomics that have received increasing attention recently. Following the crisis of 2008, many governments implemented somewhat expansionary scal policy, but were soon confronted with large increases in public debt. That gave rise to calls for austerity, i.e. government spending cuts and tax hikes aimed to decrease government debt a policy many claimed was necessary to restore con dence. It follows that a model of the economy that makes sense of the policy discussion during this time has to account for the crisis and provide a role for scal policy, while also explicitly accounting for public debt dynamics. That is the objective of this paper. The goal of this paper is to analyze public debt dynamics in a standard New Keynesian dynamic stochastic general equilibrium (DSGE) model in a low interest rate environment. One of our main ndings is that the rules for budget management change once the shortterm nominal interest rate approaches zero in a way that is important for the debate on austerity and con dence. This shows up in our model in at least two ways. First, we show that once the short-term nominal interest rate hits zero, then cutting government spending or raising sales taxes has very di erent e ects on de cits than under regular circumstances. Under regular circumstances, these austerity policies reduce the de cit roughly one-to-one. Once the nominal interest rate reaches zero, however, their e ect becomes much smaller on the de cit. These policies may even increase rather than reduce the de cit. Second, we nd that the economy is extraordinarily sensitive to expectations about the long-run at a zero interest rate. In particular, expectations about the future size of the government and future sales and/or labor taxes can have strong e ects on short-run demand. This is, again, in contrast to an economy where the nominal interest rate is positive and the central bank targets zero in ation. In that environment, we show that long-run expectations about scal policy have no e ect on short-run demand. An important implication of this is that in a low interest rate environment budget de cits can either increase or reduce aggregate demand in the short run, depending on how they in uence expectations of future taxes, spending, and monetary policy. Hence the e ect of de cit spending when the nominal interest rate is zero depends critically on the policy 1

4 regime. At a basic level, our paper highlights a general theme already emphasized in Eggertsson (2010) that once the nominal interest rate collapses close to zero, then the economy is demand-determined, i.e. the amount of stu produced is entirely determined by how much stu people want to buy. Thus, according to this framework, all emphasis should be on policies that increase aggregate spending in the short run. A key point this paper highlights is that short-run demand at a zero interest rate is not only determined by short-run scal policy, but also by expectations about the long run. The budget de cit is plausibly going to play a large role in how those long-run expectations are determined. More importantly, the way in which the budget de cit pins down those expectations depends critically upon the policy regime and can substantially a ect estimates of various policy relevant issues, such as the computation of scal multipliers currently common in the literature. The outline of the paper is detailed next. After laying out and parameterizing the model (Section 2), we rst confront it (Section 3) with the following thought experiment: Suppose there are economic conditions such that the nominal interest rate is close to zero and the central bank wants to cut rates further, but cannot. Suppose sales and labor tax rates are held constant. How does the budget de cit change if the government tries to balance the budget by cutting government spending, i.e. implementing austerity measures? The model suggests that, under reasonable parameters, the de cit declines only by a modest amount and may even increase, rather than decrease. This occurs because the cut in government spending leads to a reduction in aggregate output, thus reducing the tax base and subsequently reducing tax revenues. We derive simple analytical conditions under which the de cit increases as a result of cuts in government spending. When we conduct the same experiment with sales taxes, we obtain a similar result. To a keen observer of the current economic turmoil, then, it may seem somewhat disturbing that expenditure cuts and sales tax increases were two quite popular austerity measures in response to the de cits following the crisis of While the rst set of results points against the popular call for austerity, we have a second set of results that puts these calls, perhaps, in a bit more sympathetic light. We next consider (Section 4) the following question: How does demand in the short run react to expectations about long-run taxes, long-run productivity and the long-run size of the government? One motivation for this question is that we often hear discussion about the importance of con dence in the current economic environment and this is given as a rationale for reducing de cits. For example, Jean-Claude Trichet, then President of 2

5 the European Central Bank, said in June 2010, Everything that helps to increase the con dence of households, rms and investors in the sustainability of public nances is good for the consolidation of growth and job creation. We rmly believe that in the current circumstances con dence-inspiring policies will foster and not hamper economic recovery, because con dence is the key factor today. How does current demand, via con dence, depend on future long-run policy? To be clear, we interpret con dence as referring to e ects on current demand that come about due to expectations about long-run policy. To get our second set of results, we consider how short-run demand depends upon expectations about long-run policy. We rst look at the e ect of long-run taxes and the long-run size of the government on short-run demand if the central bank is not constrained by the zero interest rate bound and successfully targets constant in ation. In this case, we show that expectations of future scal policy are irrelevant for aggregate demand. What happens in the model is that, if the central bank successfully targets in ation, it replicates the solution of the model that would take place if all prices were perfectly exible, i.e. the Real Business Cycle (RBC) solution. Further, if all prices were exible in the model, then aggregate demand would play no role in the rst place. We then study the e ect of scal policy expectations when there are large enough shocks so that the zero interest rate bound is binding and the central bank is unable to replicate the exible price RBC solution. When this happens, the results are much more interesting: Output is completely demand-determined, i.e., the amount produced depends on how much people want to buy. Most importantly, expectations about future economic conditions start having an important e ect on short-run demand and, thus, output. In turn, future economic conditions depend on long-run policy. Our key ndings are that a commitment to reduce the size of the government in the long run or to reduce future labor taxes increases short-run demand. This is because both policies imply higher future private consumption, and thus will tend to raise consumption demanded in the short run. It is worth noting that any policy that tends to increase expectations of future output will also be expansionary in the same way. Meanwhile, a commitment to lower long-run sales taxes has the opposite e ect, i.e., it reduces short-run demand. This is because lower future sales taxes induce people to delay short-run consumption to take advantage of lower future prices. In Section 5, we analyze how debt dynamics may a ect short-run demand. Taking short-run de cits as given, we ask: What are their e ects on short-run demand given that they need to be paid o in the long run? In this case, we show that the e ect of de cits depends as a general matter on the policy regime. If the de cits are paid o by a 3

6 reduction in the long-run size of the government spending or higher long-run sale taxes, then the budget de cits are expansionary. If they are paid o by higher long-run labor taxes, then the budget de cits are contractionary. In Section 6, we look at some numerical examples. Section 7 shows how the picture changes once we account for the possibility of the government defaulting on its debt. Finally, we review that de cits are expansionary if they trigger expectations of medium-term in ation. 1.1 Related literature The paper builds on Eggertsson (2010), who addresses the e ects of taxes and spending on the margin, and a relatively large amount of literature on the zero interest rate bound (see in particular Christiano, Eichenbaum and Rebelo (2011) and Woodford (2011) for related analysis and more recently Rendahl (2012)). The contribution of this paper to the existing literature is that we study public debt dynamics and the interactions between output and debt, and between taxes and spending. An additional feature of the current paper is the greater attention to the short-run demand consequences of long-run taxes and spending. While there is some discussion in Eggertsson (2010) on the e ect of permanent changes in scal policy, we here make some additional, but plausible assumptions, that allow us to illustrate the result in a much cleaner form and additionally illustrate some new e ects. We consider the simple closed-form solution as a key contribution to the relatively large recent literature that studies the interaction of monetary and scal policy at the zero bound (see e.g. Leeper, Traum, Walker (2011) and references therein). Our focus here is not on optimal policy. Instead we look at the e ect of incremental adjustments in various tax and spending instruments at the margin. The hope is, of course, that these partial results give some insights in the study of optimal policy. A challenge for thoroughly studying optimal policy with a rich set of taxes (such as here) is that, in principle, the rst best allocation can often be replicated with exible enough taxes, as illustrated in Eggertsson and Woodford (2004) and Correia et al. (2011). Yet, as the current crisis makes clear, governments are quite far away from exploiting scal instruments to this extent. Most probably this re ects some unmodeled constraints on scal policy that prevent their optimal application. But even with these limitations, we think it is still useful to understand the answer to more speci c questions, such as What happens to output and the de cit if you do X? The answer to this question often drives policy decisions. A politician, for example, may ask: Can I reduce the budget de cit by doing A, B or C? 4

7 The result that cuts in government spending can increase the de cit is close to the nding in Erceg and Linde (2010) that government spending can be self- nancing in a liquidity trap. Relative to that paper, the main contribution is that we, rst, show closed-form solutions for de cit multipliers and, second, we model how expectations of long-run policy may change short-run demand. The demand e ect of the long-run labor tax policy is similar to that documented by Fernandez-Villaverde, Guerron-Quintana and Rubio-Ramirez (2011) and the permanent policies in Eggertsson (2010). The fact that a commitment to smaller government in the future can increase demand at the zero interest rate bound is illustrated in Eggertsson (2001) and Werning (2011). Eggertsson (2006) analyzes, in more detail, how de cits can trigger in ation expectations. 2 A simple New Keynesian model We only brie y review the microfoundations of the model here, for a more complete treatment see Eggertsson (2010). The main di erence between our model and the model from Eggertsson (2010) is that we are more explicit about the government budget constraint. There is a continuum of households of measure 1. The representative household maximizes X 1 Z 1 T t T u(c T ) + g(g T ) v(l T (j))dj ; E t T =t h R 1 where is a discount factor, C t c 0 t(i) 1 is the Dixit-Stiglitz aggregate of consumption of each of a continuum of di erentiated goods with an elasticity of substitution i i 1 di h R 1 equal to > 1, P t p 0 t(i) 1 di is the Dixit-Stiglitz price index, and l t (j) is the quantity supplied of labor of type j. Each industry j employs an industry-speci c type of labor, with its own real wage W t (j): The disturbance t is a preference shock, and u() and g() are increasing concave functions, while v() is an increasing convex function. G T is the government spending and is also de ned as a Dixit-Stiglitz aggregate analogous to private consumption. For simplicity, we assume that the only assets traded are one-period riskless bonds, B t. The period budget constraint can then be written as Z 1 (1 + s t)p t C t + B t = (1 + i t 1 )B t 1 + (1 I t ) Z t (i)di (1) 0 Z 1 +P t W t (j)l t (j)dj P t T t ; where Z t (i) stands for pro ts that are distributed lump-sum to the households. 0 There are three types of taxes in the baseline model: a sales tax s t on consumption purchases, 5

8 a lump-sum tax T t and an income tax I t (levied on income from both labor and the household s claim on rms pro ts). 1 The household maximizes the utility subject to the budget constraint, taking the wage rate as given. It is possible to include some resource cost of the lump-sum taxes, for example that collecting T t taxes consumes s(t t ) resources as in Eggertsson (2006) and total government spending is then de ned as F t = G t + s(t t ). Since we will not focus on the optimal policy, this alternative interpretation does not change any of the results. There is a continuum of rms of measure 1. Firm i sets its price and then hires labor inputs necessary to meet realized demand, taking industry wages as given. A unit of labor produces one unit of output. The preferences of households and the assumption that the government distributes its spending on varieties in the same way as households imply a demand for good i of the form y t (i) = Y t ( pt(i) P t ), where Y t C t + G t is aggregate output. We assume that all pro ts are paid out as dividends and that rms seek to maximize pro ts. Pro ts can be written as Z t (i) = p t (i)y t (p t (i)=p t ) W t (j)y t (p t (i)=p t ) ; where i indexes the rm and j indexes the industry in which the rm operates. Following Calvo (1983), let us suppose that each industry has an equal probability of reconsidering its price in each period. Let 0 < < 1 be the fraction of industries with prices that remain unchanged in each period. In any industry that revises its prices in period t, the new price p t will be the same. The maximization problem that each rm faces at the time it revises its price is then to choose a price p t to maximize ( 1 ) X max E t () T t T (1 P p T )[p t Y T (p t =P T ) W T (j)y T (p t =P T ) ] ; t where T T =t is the marginal utility of the nominal income for the representative household. An important assumption is that the price that the rm sets is exclusive of the sales tax. This means that if the government cuts sales taxes, then consumers face a lower store price by exactly the amount of the tax cuts for rms that have not reset their prices. Without going into details about how the central bank implements a desired path for 1 In an earlier variation of this paper, we assumed instead that only wages were subject to the income tax. Since wages are exible, in this model, wages drop by more than output in a recession. This leads to a disproportionate drop in tax revenues in a recession that we felt exaggerated our results and relied too much on the complete exibility of wages in the model. Under this alternative benchmark assumption, which is more conservative, income tax is proportional to aggregate output (any drop in real wages will be re ected by an increase in pro ts, and taxing pro t and wages at the same rate means we abstract from this redistribution aspect of the model). 6

9 nominal interest rates, we assume that it cannot be negative so that 2 i t 0: The government s budget constraint can now be written as 3 b t = (1 + i t 1 )b t 1 1 t + (1 + s t)g t + (1 I t )Y t T t (1 + s t)y t, where b t Bt P t is the real value of the government debt and t Pt P t 1 is gross in ation. Note that we take into account that the government both pays the consumption tax s t and receives this tax back as revenues. If we wrote the budget constraint in terms of private consumption, C t ; this would net out. The model is solved by an approximation around a steady state and we linearize it around a constant solution with positive government debt b > 0 and zero in ation 4. The consumption Euler equation of the representative household combined with the resource constraint can be approximated to yield ^Y t = E t ^Yt+1 (i t E t t+1 r e t ) + ( ^G t E t ^Gt+1 ) + s E t (^ s t+1 ^ s t), (2) where i t is the one-period risk-free nominal interest rate, t is in ation, E t is an expectation operator, the coe cients are ; s > 0; ^Y t log Y t = Y, ^Gt log G t = Y, while ^ s t s t s, and r e t is an exogenous disturbance that is only a function of the shock t (for details see footnote on the rationale for this notation). 5 Aggregate supply (AS) is t = ^Y t + ( I^ I t + s^ s t 1 ^Gt ) + E t t+1 ; (3) where the coe cients ; > 0 and 0 < < 1 and the zero bound is i t 0. 2 See e.g. Eggertsson and Woodford (2003) for further discussion. 3 To derive this, note that since pro ts by rm i are given by Z t (i) = p t (i)y t (p t (i)=p t ) P t W t (i)l t (i) where we have used the Dixit-Stiglitz demand to substitute for y t (i). Then, we can aggregate to obtain Y t P t = R 1 0 Z t(i)di + P t R 1 0 W t(j)l t (i)di: This can be substituted into the representative household budget constraint. Then, using equation (1), we obtain the expression in the text. 4 The steady state level of debt, b, is not pinned down by our theory and thus we could pick various values for b. 5 1 The coe cients of the model are de ned as follows u ccy ;! v l ; 1 +! ; ; where a bar denotes that the variable is de ned in steady state. The shock is de- (1 )(1 ) 1 +! 1+! ned as r e t r + E t (^ t ^t+1 ); where ^ t log t = and r log 1 : Finally we de ne I 1 1 I and s 1 1+ s : In terms of our previous notation, i t now actually refers to log(1 + i t ) in the log-linear model. Observe also that this variable, unlike the others, is not de ned in deviations from steady state. We do this so that we can still express the zero bound simply as the requirement that i t is nonnegative. For further discussion of this notation, see Eggertsson (2010). 7 u c v ll L

10 The government budget constraint can be approximated to yield b Y ^b t b Y (1 + r)^b t 1 = b Y (1 + r)[^{ t 1 t ] + (1 + s ) ^G t ( I + s ) ^Y t ^ I t C Y ^ s t ^T t, (4) where ^b t log B t =P t log b and ^T t log T t = Y. What remains to be speci ed is government policy, i.e. how the government sets taxes, spending and monetary policy. We will be speci c about this element of the model once we set up the shocks perturbing the economy. 2.1 The long run and short run: Output, in ation, budget de cits To solve the model and take the zero bound explicitly into account, we make use of a simple assumption now common in the literature based on Eggertsson and Woodford (2003). A1 In period 0, there is a shock rs e < r which reverts to a steady state with a probability 1 in every period. We call the stochastic period in which the shock reverts to steady state t S and assume that (1 )(1 ) > 0: As discussed in Eggertsson (2010), we need to impose a bound on to avoid multiplicity which is stipulated at the end of A1. 6 For scal policy, we assume that A2 ^ I t = ^ s t = ^G t = 0 for 8 t and future lump sum taxes ^T t are set so that the government budget constraint is satis ed, while ^T t = 0 for 8 t < t S : For monetary policy we assume that A3 Short-term nominal interest rates are set so that t = 0. If this results in i t < 0, we assume i t = 0 and t is endogenously determined. By assumption 3, we focus on the equilibrium in which in ation is zero if it can be achieved taking the zero bound into account. In this paper, we do not address how this equilibrium is implemented, e.g. via which interest rate policy and scal policy commitment, but there are several ways of doing this. What we are primarily interested in here is comparative statics for scal policy in the short run when the zero bound is binding and the central bank is unable to target zero in ation so that in ation becomes an endogenous object. Given assumptions A1 and A2, the policy commitment in A3 implies that 6 See Mertens and Ravn (2010) for a discussion of multiple equilibria in this setting. 8

11 t = ^Y t = 0 for t t S. In the short run, either t = ^Y t = 0 (as long as the zero bound is not binding, i.e. i t = r e t > 0) or t and ^Y t are determined by the two equations S t = ^Y t S + E t S t+1 (5) ^Y t S S = (1 )E t ^Y t+1 + (1 )E t S t+1 + rs; e (6) where S denotes the short run and we have substituted for i S t solved to yield the rst proposition. = 0: These equations can be Proposition 1 Suppose A1, A2, and A3 hold and that rt e < 0: Then there is a unique bounded solution for output and in ation at zero short-term interest rates given by 1 t = S = (1 )(1 ) re S < 0 for 0 t < t S (7) ^Y t = ^Y 1 S = (1 )(1 ) re S < 0 for 0 t < t S : (8) The proof of this proposition follows from the fact that one eigenvalue of the system (5)-(6) has to be outside of the unit circle and the other inside it so the proof follows from Blanchard and Kahn (1983). 7 Given this unique bounded solution, we will subsequently suppress the subscript t in the short run (when possible) and instead simply write S and ^Y S to denote the endogenous variables in the time periods 0 t < t S : We can also derive a short-run evolution of the de cit. Recall that according to A2 we assume that the lump-sum taxes are at their steady state in the short run, i.e. ^Tt = 0 for 0 t < t S : Hence all adjustments will need to take place with long-run lump-sum taxes, while tax rates stay constant throughout. Under these assumptions, we obtain the following proposition for short-run de cits. Proposition 2 Suppose A1, A2 and A3 hold. Then, the de cit in the short run is given by where ^D S is the de cit. ^D S = b Y ^b b t Y (1 + {)^b t 1 = b Y (1 + {)[^{ S S ] ( I + s ) ^Y S 8 < 0 if rs e = > 0 : b r [ b Y (1+{)+( I + s )(1 )] r e Y (1 )(1 ) S > 0 if re S < 0 7 See Eggertsson (2010) for a more detailed proof in a similar context where the analytical expressions of this equation system are derived. 9

12 This proposition follows directly from the government budget constraint in equation (4), the policy speci cation and the last proposition. Observe that as output goes down the de cit automatically increases, since income and sales tax rates are at their steady state. Then, it follows that less will be collected from these taxes, which will be discussed in more detail in the following sections. It is worth commenting brie y on Assumption 2, since it is driving the de cit. The basic idea is to assume that taxes that are proportional to the aggregate variables, such as sales and income taxes, stay constant at the pre-crisis rate and explore what happens to the government debt under this assumption. We think that this is a reasonable characterization of scal policy in practice, at least for the purpose of comparative statics. The way in which scal policy is discussed in the political spectrum is typically in the context of tax rates. Thus, a temporary increase in the tax rate is a tax increase and vice versa because this is typically at least in very broad terms the decision variable of the government. We are assuming that, in order to pay for current or future short-run de cits, there is an adjustment in future lump-sum taxes (that may have welfare e ects due to resource costs). This assumption, however, is not made for the sake of realism, but to clarify the di erent channels through which current and future taxes can change debt dynamics and short-run demand. It is a natural rst step to assume that future lump-sum taxes adjust, since they are neutral due to Ricardian equivalence. We elaborate on this more in coming sections when we move away from this assumption and instead start to assume more realistically that the future tax burden is nanced via distortionary taxes. 2.2 Calibration In the next section, we consider several policy experiments and will derive all of them in closed form. Before getting there, however, it is helpful to parameterize the model in order to translate our closed-form solutions into numerical examples. To do this, we parameterize the model using Bayesian methods described in more detail in Denes and Eggertsson (2009). We illustrate two baseline examples and we choose the parameters and the shock to match two scenarios. The rst is an extreme recession that corresponds to the Great Depression, that is, a 30 percent drop in output and 10 percent de ation. The other scenario is less extreme with a 10 percent drop in output and a 2 percent drop in in ation. We call the rst numerical example the Great Depression scenario and the second the Great Recession scenario (abbreviated GD and GR for the rest of the paper). The parameters and the shock are chosen to match these scenarios exactly, while at the 10

13 same time matching as closely as possible the priors we choose for both the parameters and the shocks shown in Table 1. Recall that the shock, rl e ; is only driven by a shift in the preference parameter t and has the interpretation of being the short-term real interest rate if all prices were exible. We use the same priors as in Denes and Eggertsson (2009). The posterior is approximated numerically by the Metropolis algorithm and is derived explicitly in Denes and Eggertsson (2009). Tables 2 and 3 show the posterior distribution for the two scenarios. We calibrate scal parameters s and I to 0:1 and 0:3, respectively. We calibrate the steady state debt-output ratio to correspond to 75 percent of annual output and the real government spending to output ratio to 20 percent of annual output. As the tables suggest, the most important di erence across the two scenarios is that the shock is more persistent in the case of the GD scenario, thus leading to a more severe output contraction and de ation. Table 1: Priors for the structural parameters and the shocks distribution prior 5% prior 50% prior 95% beta beta beta gamma ! gamma gamma r L gamma Tables 2.Posterior for the Great Recession (GR) calibration post 5% post 50% post 95% posterior mode ! r L Tables 3.Posterior for the Great Depression (GD) calibration 11

14 Interest Rate Government Deficit Output Inflation post 5% post 50% post 95% posterior mode ! r L Austerity plans 3.1 De cits in a liquidity trap Great Recession Time Great Depression Time Time Time Figure 1: The Great Depression and the Great Recession in the model Figure 1 shows the evolution of output, in ation and the nominal interest rate under our baseline parameterization. Recall that the parameters were chosen to replicate the Great Depression scenario and the Great Recession scenario in terms of the drop in 12

15 output and in ation. The gure shows one realization of the shock, i.e. when it lasts for 10 quarters. Output and in ation drop due to the shock (panel (a) and (b)), and the nominal interest rate collapses to zero (panel (c)). Panel (d) is of the most interest, relative to previous work, as it shows the increase in the de cit of the government due to the crisis given by ^D S = b Y (1 + {)[^{ S S ] ( I + s ) ^Y S : (9) As we see in panel (d) the de cit increases by 4.5 percent of GDP in the GR scenario and 18.8 percent in the GD scenario. One unit of de cit corresponds to the shortfall in the government s nances between spending and taxation as a fraction of GDP. The increase in the de cit is from two main sources. The rst term re ects the contribution of the interest rates to the de cit and the revaluation of the nominal debt due to changes in the price level (i.e. de ation will increase the real value of the debt). The second term represents the drop in sale and income tax revenues due to the fact that overall output is reduced and, hence, tax collection drops. Of these two channels, it is the second that is driving most of the action, i.e. the de cit is increasing mostly because the tax base (output) is shrinking. A key assumption in this model is that all income (from either pro ts or wages) is taxed at the same rate I t. The implication of this can be seen in equation (9) which says that every percentage deviation of output from steady state results in an increase in the de cit by a factor of ( I + s ): Given our calibration, this implies that a percentage deviation of output from steady state would increase the de cit by 0.4 percent, which is consistent with the numbers reported for U.S. data by Follette and Lutz (2010) (they report 0.45 for the sum of federal and local tax revenues and 0.35 for federal taxes only). One alternative speci cation for income tax would be to assume that it is only levied on wages and not on pro ts. In this case, this elasticity would be much larger, since wages are exible in the model and tend to drop by more than output. A natural question from the point of view of a policymaker is: How can we balance the budget in the face of de cits? Here we illustrate three austerity plans which aim for short-run stabilization of the de cit. The rst plan is to cut government spending, the second is to increase sales taxes and the third is to increase labor taxes. Of these, the rst two plans are much less successful in reducing de cits in the zero bound environment while the last one is more e ective. More explicitly, we study the following policies which replace A2. A4 Let (^ I t ; ^ s t; ^G t ) = (^ I L; ^ s L; ^G L ) = 0 for 8 t t S and (^ I t ; ^ s t; ^G t ) = (^ I S; ^ s S; ^G S ) for 8 0 t < t S. Lump-sum taxes ^T t at dates t t S are set so that the government budget 13

17 rates Table 4: Tax and spending output multipliers at positive and zero interest i > 0 i = 0 GD GR GD GR [5%, 95%] [5%, 95%] [5%, 95%] [5%, 95%] ^Y S 0.4 ^G S [0.2, 0.6] ^Y S ^ s S ^Y S ^ I S -0.3 [-0.5, -0.2] -0.5 [-0.8, -0.3] 0.4 [0.3, 0.6] -0.3 [-0.5, -0.2] -0.5 [-0.7, -0.3] 2.2 [1.4, 3.2] -1.8 [-3, -0.9] 0.4 [0.2, 0.5] 1.2 [1.1, 1.5] -0.9 [-1.3, -0.5] 0.1 [0.06, 0.3] These propositions and Table 4 illustrate that the government spending multiplier is much higher at a zero interest rate than at a positive interest rate, and this is true under both baseline calibrations. The reason for this is outlined in some detail in Eggertsson (2010) and is summarized below. At a positive interest rate, any increase in demand due to government spending will be o set, to some extent, by an increase in the nominal interest rate, as the central bank seeks to keep in ation at a target rate. At a zero interest rate, however, in ation is below the central bank target due to the shock r e t. Hence, any increase in demand via government spending is perfectly accommodated by the central bank and the nominal interest rate stays the same. But there is a second force at work here the e ect of the expectations. Even if the central bank perfectly accommodates government spending in the short run, this by itself will only result in a one-to-one increase in output. 8 Yet, as the table shows, the multiplier is much higher than one. The reason for this is that government spending increases output not only because of an increase in current spending, but also through expectations about higher future government spending in future states when the zero bound is binding. This channel is particularly important in the GD calibration since the probability of staying in the crisis state (the short run ) is higher than in the GR calibration. Much of the recent literature on scal multipliers emphasizes the large range for the multipliers one can get out of the models (see e.g. Leeper et al (2011)). Perhaps somewhat surprisingly we see that, for each of the calibrations, the 5 to 95 percent range of the posterior of each of the multipliers is not very large. For the GD calibration of the gov- 8 To see this, consider the case in which the shock goes back to zero in the next period so that = 0. Then equation (10) shows that output increases one-to-one with spending. 15

18 ernment spending multiplier when the zero bound is binding, the 5 to 95 percent posterior band is 1.4 to 3.2. While this range is not trivial, it is relatively narrow in comparison to many other studies. We see that this is the case, despite the fact that the priors chosen for the calibration are not very tight (see Table 1). The main reason for this tight interval is that the scenario we choose, i.e. the Great Depression and the Great Recession, puts relatively strong restriction on the model, so that conditional on matching these scenarios, the prediction of the model is relatively sharp as further discussed in Denes and Eggertsson (2009). This is in contrast to many other studies that do not impose as strong of a restriction on what the model is supposed to generate as a benchmark. Meanwhile, we see that there is a considerable di erence between the multipliers in the GD and GR scenarios at a zero interest rate. In fact, the 5 to 95 percent posterior intervals of the zero bound government spending multiplier barely overlap. This highlights that the main source of the di erence in our estimate for the multiplier is the scenario the model is supposed to match. As the output drop in a given scenario becomes larger, the multiplier increases. As already noted, the key di erence between the two scenarios is that the shock is more persistent in the GD case. Hence, it is the expectational channel of government spending that is driving the di erence here, i.e., the expectation of spending in future states of the world in which the zero bound is binding. 3.2 The e ect of cutting government spending on de cits We now turn to the idea of cutting government spending to reduce the de cit. By equation (4), we see that this results in 4 ^D S 4 ^G S = (1 + s ) 4 ^G S 4 ^G S + b Y (1 + {)4[^{ S S ] 4 ^G S ( I + s ) 4 ^Y S 4 ^G S : For the budget to be balanced via this austerity policy, this number needs to be positive. Consider rst what happens at a positive interest rate. One can con rm that 4 ^G S 4 ^G = 1; S 4[^{ S S ] 4 ^G = (1 ) 1! and 4 ^Y S S 4 ^G = 1 ; yielding the next proposition. S Proposition 5 Suppose A1, A3 and A4 hold. At a positive interest rate, cutting government spending always reduces the de cit. This reduction is given by 4 ^D S 4 ^G S = 1 + s + b Y (1 + {)(1 ) 1! ( I + s ) 1 > 0 if i S > 0 (i.e. r e S > 0): 16

20 Let us now interpret this. The rst term is the same as in the prior proposition, namely 1 + s, which means that a dollar cut in government spending will result in a reduction of the de cit by the same amount. In partial equilibrium, thus, any drop in spending reduces the de cit by that amount. The other terms, as before, come about due to the general equilibrium e ects but now they have much more power. A cut in government spending does not only lead to a drop in government expenditures. It will also result in a reduction in government revenues, due to the fact that it leads to a reduction in the overall level of economic activity and wages and through that, a change in the price level which may raise the real value of the outstanding nominal debt. All of these general equilibrium e ects are captured in the expression above. The rst term captures the increase in the real value of debt if the government cuts spending through de ation. This term is much bigger than before. The second term measures the reduction in sales tax and income taxes due to the drop in output. Table 5 computes the value of the de cit multiplier for the two scenarios. As we can see, the de cit increases more than one-for-one for the GD scenario, i.e. a dollar cut in the spending increases the de cit by 30 cents. The GR scenario is much less extreme and a cut in government spending does in fact reduce the de cit. But it does so by less than one-toone, a one dollar cut in the government spending reduces the de cit by only about 50 cents. Flipping this around, we see that, in the GD case, government spending is self- nancing, while in the GR case the endogenous increase in output lls about half the gap created in the budget, i.e. for a dollar increase in spending, the de cit only increases by half that much. The table also reports 5 to 95 percent posterior bands. We see that, given our priors for the parameters, this posterior band is most of the time in the self-defeating austerity region for the GD case while in the GR calibration mostly in the other way around. The main reason for the discrepancy between the GD and the GR calibration is that the government spending multiplier is much larger under the Great Depression (2.2) scenario than in the Great Recession scenario (1.2). To see this note that the proposition implies that 4 ^D S 4 ^G < 0 if 4 ^Y S S 4 ^G > = 1 + s + (1 + {) S I + s + b (1 + {) b Y Y In other words, if the multiplier of government spending is larger than :, then the de cit will always increase when the government cuts spending at a zero interest rate. Also, note that the outcome in the GD scenario was more extreme, due to a more persistent fundamental shock, and thus there is more room for government spending to step in and trigger an increase in output and prices. 18

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